Time to yield to high-yield bonds

Over the 10 years to 31 March 2016, European high-yield bonds recorded a 55 per cent correlation with investment-grade bonds, but a 73 per cent correlation with European equities.

Long-term asset class return correlations

Source: Merrill Lynch, Iboxx, JP Morgan, RIMES 31 Mar 2016. Correlations of monthly returns since 2006

Of course, past performance is no guide to the future. But historically, the correlation has been strong because the price of a high-yield bond has different drivers than a straightforward investment-grade bond. It is not an equity – but at the same time, it is not a conventional bond.

When you invest in equities, you receive dividend income, together with the potential for capital gains if earnings are on an upward trajectory. But equities can be volatile; because there is no maturity date, they are characterised by almost infinite duration.

In contrast, with a high-yield bond, if you buy a five-year bond with a 5 per cent coupon, you will collect the coupon (aka interest) each year.

Let us illustrate the difference with imaginary company XYZ plc. Its expected sales growth is 10 per cent a year. Accordingly, its shares will be valued with a super multiple. But if those earnings expectations are revised downwards, the fall in the share price can be precipitous. As soon as a company goes ex-growth, its share price may fall dramatically, because as soon as a company loses its growth-stock ‘halo’, equity markets will punish it severely.

Contrast that with the experience of the investor in XYZ’s high-yield bonds. All things being equal, if the balance sheet still works when revenues are growing at 2 per cent, high-yield investors do not really care whether earnings growth is 5 per cent or 10 per cent. As long as the cash flows are sufficient to pay the coupon, bondholders care to a lesser extent whether the growth rate is slowing. That is an equity story. The price of the bond might have been dented – but to nothing like the same extent as the company’s equity. As long as the balance sheet continues to work, by which we mean that the debt levels remain sustainable, high-yield investors are much more protected from the downside.

And do not forget – coupons on bonds are contractual; a dividend is not. Instead, a dividend represents a promise – best endeavours. Additionally, bonds rank higher in a company’s capital structure than equities, which provides further relative downside protection in a worst-case scenario (default). Long-term average recovery rates for high-yield bonds are north of 30 per cent. Equities, by definition, recover very little after restructuring or liquidation.

Investing in high-yield bonds, the emphasis is different. The focus is on the avoidance of downside risk, and this entails in-depth due diligence. While the high-yield manager will perform a great deal of cash flow modelling, the main focus should be on the sustainability of the investment’s capital structure. And while it is important to understand the potential upside of any investment, it should be understood that the vast majority of return in high yield comes from the coupon. If you can avoid the ‘blow-ups’ – instances where companies lurch towards default – this will stand you in good stead.

Just like the equity analyst, the high-yield investor will examine a company’s balance sheet, its covenants, its net income statement, cash flows, liability structure and legal jurisdiction. However, the emphasis is different. High-yield investors are less interested in the growth story and more interested in ensuring that they are being paid the appropriate level of income to offset the downside risks.

Take the customer base. It is much better to invest in a business with 500 customers than in one with 20 customers. In the latter instance, the loss of a big contract could impair the company’s credit quality. But in the case of the larger company, a much more diverse revenue base represents more of a hedge against the loss of a few contracts.

When scrutinising the ongoing investment requirements of the business, while many analysts will focus on earnings before interest, tax, depreciation and amortisation (Ebitda), it is important to look at this figure after capital expenditure.

The reason? A company can cut dividends. But what are the investment requirements of the business? If times become tough, can it afford to pare back capital expenditure? If so, it can continue to preserve cash flow and thus easily service the debt structure.

High-yield analysis involves looking at the downside in every scenario: higher costs; lower revenues; lower cash flows. They should look closely at covenants. If a company is going to trigger covenants, that could potentially signal default. Are the company’s bankers motivated to show forgiveness and forbearance in such a scenario?

The characteristics of high-yield bonds are more akin to those of equities than their investment grade counterparts. But for high-yield investors, the thrust of the analysis is quite different: rather than seeking out the next ‘growth’ story to profit from the potential upside, they will seek primarily to avoid the ‘blow-ups’ and defaults that would threaten the return on our investment.

Steven Logan is head of global high yield at Aberdeen Asset Management